Consider a world in which a firm’s interest payments on debt are tax deductible.
ID: 2794989 • Letter: C
Question
Consider a world in which a firm’s interest payments on debt are tax deductible. What happens? a. If there are also no financial distress costs, then firms will go to 100% leverage b. If there are also no homemade leverage costs, then firms will go to 0% leverage c. If the firm’s cash flows (EBIT) are also riskless, then firms will go to 100% leverage d. If there are financial distress costs, then firms will go to 100% leverage e. If there are homemade leverage costs, then firms will go to 100% leverage f. None of these
Explanation / Answer
As per MM model ( with taxes)
Proposition 1: when there is interest tax shield , 100 % debt financing ratio is optimum.
Proposition 2: WACC is minimised at 100% debt.
As per above discussion the correct option is a. In case of no financial distress, firm can go for 100 % leverage.